What is money



What is money? How is it created? When does it matter to the economy?

Money is any commodity or token that is generally acceptable as a means of payment.

A means of payment is a method of settling a debt.

Money has four functions:

1. Means of payment

Paying people what you owe them

2. Medium of exchange

Avoid Barter. Sell for money, then use the money to buy another good.

3. Unit of account

List prices as in a catalogue or list debts as in an account book.

4. Store of value

Hold money now in order to buy goods later.

Money in Canada Today

Money in Canada consists of

▪ Currency (bills and coins)

▪ Deposits at banks and other financial institutions, such as chequing accounts.

M1 is narrowly defined money.

It is currency in circulation – in your pockets or in cash registers and money in chequing accounts (demand deposits) at chartered banks.

M2 + is more broadly defined money.

It includes:

1. M1

2. plus personal savings deposits at chartered banks,

3. plus nonpersonal (business) notice deposits (savings accounts) at chartered banks, deposits at trust and mortgage loan companies,

4. deposits at credit unions and caisses populaires, and deposits at other financial institutions.

Cheques, debit cards and credit cards are not money.

Cheques and debit cards are methods of instructing your bank to take money out of your account and put it into some one else’s account.

Credit cards are a means of instantaneously qualifying for a loan and instructing a financial institution to transfer the sum of the loan to the person you are buying from. So if you pay $25 for a CD, you are simultaneously negotiating a loan from Visa, and telling Visa to give the money you borrowed to the music store. You are obliged to transfer money to Visa later.

Cheques, debit cards and credit cards greatly increase the efficiency of our banking system, and they influence how much cash we keep in our pocket or chequing account, but they are not money.

The definition of money is somewhat arbitrary.

One principle is that narrowly defined money earns no interest as in deposit accounts or cash in your pocket.

Some broadly defined money earns interest, as in savings accounts, but it earns much less than government bonds.

In general, the more liquid money is, that is the more easily it is spent, the less interest it will earn and the more like money it is.

Cash, most chequing accounts: zero interest.

Savings accounts: low interest.

Before debit cards, you had to transfer funds from a savings account to a chequing account or to cash to spend it.

G.I.C.’s, Canada Savings Bonds, R.E.S.Ps must be cashed in to be spent, sometimes at a penalty in interest rates. They are not money.

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Chartered Banks

A chartered bank is a private firm that is licensed to receive deposits and make loans.

A chartered bank’s balance sheet summarizes its business and lists the bank’s assets, liabilities, and net worth.

The objective of a chartered bank is to maximize the net worth of its stockholders.

To achieve its objective, a bank makes loans at an interest rate higher than that paid on deposits.

The riskier the loan, the higher the interest rate you must pay the bank.

But the banks must balance profit and prudence; loans generate profit, but depositors must be able to obtain their funds when they want them.

Banks lend out depositors’ money, but they must pay pack the money on demand.

They could always pay all the money back, no matter what, if they kept all deposits in the vault. But then they couldn’t make loans, and wouldn’t make a profit. They would have to charge a storage fee to cover the costs of bookkeeping and protecting the vault.

Banks keep a portion of deposits as RESERVES – funds available to pay the depositors what they owe them.

Banks now can decide the proportion of deposits they wish to hold as cash.

Reserves are:

1. Vault Cash or currency

2. Deposits at the Bank of Canada (The Bankers Bank, controlled by the Gov’t.)

These deposits can be cashed on demand for more currency

Bank Assets that pay interest and contribute to profit.

1. Banks also hold highly liquid and safe assets, such as government treasury bills. These are short term bonds of the government. They pay interest and are not money. The smallest are for $10,000. They are payable in 30, 60 or 90 days, so they can fairly quickly be turned into cash.

2. Other financial securities, such as 20 year government or corporate bonds. These can be sold at any time, but because it is so long until the issuer must repay them, the price at which they sell may vary. If the corporation that issued them goes bankrupt, they will become worthless.

3. Loans to firms and to individuals. The riskier the loan, the higher the interest. If you are starting a business, you will likely have to pay a high loan, because the risk of your being unable to repay the loan is high. But Nova Scotia Power Corporation can pay a low rate (usually prime), because it is not likely to go bankrupt.

The sum of the banks assets equal the value of the banks liabilities – the money it owes its depositors, that is

Vault cash + Deposits with the bank of Canada + treasury bills + other liquid assets + loans to firms and individual = deposits of the public in the banks.

If everyone demanded that their bank deposits be redeemed in currency today, banks would be unable to repay them.

The reserves of vault cash are much less than the value of the deposits.

The banks can ask the Bank of Canada to cash their deposits and send them currency (the truck with the cash would have to drive here). But the bank’s deposits are much less than what the banks owe their depositors.

The banks can sell their treasury bills and other bonds, although all banks would be selling these assets at the same time. Their prices would fall sharply, and be much lower than their purchase price.

The banks can’t demand immediate payment of your student loan.

If everyone demanded that any bank repay all its depositors immediately, every bank would fail (be unable to repay depositors).

Individual banks have failed. Some deposits are insured by the government. Eventually depositors were repaid this money. Other deposits were not insured, and the depositors lost their money.

If all banks fail, there would be a massive financial crisis. Many banks failed in the United States and in Europe (not Canada) during the early 1930s and contributed substantially to the severity of the depression.

Financial stability is extremely important to a well functioning economy

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